June 2, 2015

Wholly Underwater Junior Liens May Not Be Stripped Off in Chapter 7 Bankruptcy Proceedings

by the Bankruptcy, Reorganization and Capital Recovery group

The U.S. Supreme Court has held that a debtor in a Chapter 7 bankruptcy proceeding may not void a junior mortgage lien when the debt owed on a senior mortgage lien exceeds the current value of the collateral, provided that the junior creditor’s claim is both secured by a lien and allowed under the Bankruptcy Code. The widely anticipated June 1 decision, which was unanimous with the exception of three justices not joining in a footnote, rejected a line of 11th Circuit cases allowing numerous debtors to file motions and complaints challenging underwater junior liens. Although the Court’s ruling was in the context of residential mortgage loans in Chapter 7 cases, the decision will also benefit commercial lenders in Chapter 7 cases.

Section 506(d) of the Bankruptcy Code provides that “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” The question before the Court was whether pursuant to Section 506(d) of the Bankruptcy Code, a Chapter 7 debtor may extinguish or “strip off” a junior mortgage lien in its entirety when the outstanding debt owed to a senior lienholder exceeds the current value of the collateral. The question of stripping off junior liens arose in two cases where the bank held a second-priority mortgage lien on the debtors’ respective houses, and the value of the houses was less than the amount owed to the first-priority lienholder.

The bank’s arguments on appeal relied primarily on the Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992), which held that when property securing a loan is worth less than the debt owing on the loan—that is, the loan is “underwater”—the Bankruptcy Code does not permit a Chapter 7 debtor to “strip down” the lien to the current value of the property. In doing so, the Court construed Section 506(d) of the Bankruptcy Code to void a lien only when the underlying right to payment the lien secures is invalid. Section 506(d), the Dewsnup Court held, does not reduce such partially secured liens to the current value of the collateral, reasoning that “[i]t is simply ‘not plausible’ that Congress intended to grant debtors that ‘broad new remedy . . . without [its] being mentioned somewhere in the Code itself or in the annals of Congress.’” Id. At 420. Rather, under Chapter 7 of the Bankruptcy Code as under more than a century of pre-Code practice, liens securing valid claims “pass through bankruptcy unaffected,” irrespective of their partially secured status.

Relying on Dewsnup, the bank argued that as Section 506(d) does not permit a Chapter 7 debtor to “strip down” the mortgage lien to the current value of the house, itshould be extended to cover wholly underwater mortgages. While the debtors did not seek to have the Court overrule Dewsnup, they did argue that the decision should be limited to partially—as opposed to wholly—underwater liens. The Supreme Court rejected all of the debtors’ arguments.

The Court noted that its definition of “secured claim” in Dewsnup did not depend on whether the lien was partially or wholly underwater. The Court stated that the “debtors’ distinction would not vindicate [Section] 506(d)’s original meaning, and it would leave an odd statutory framework in its place.” For instance, under the debtors’ approach, if a court valued the collateral at $1 more than the amount of the senior lien, the debtor could not strip down a junior lien under Dewsnup, but if it valued the property at $1 less, the debtor could strip off the entire junior lien. Thus, “[g]iving the constantly shifting value of real property,” the Court felt that “this reading could lead to arbitrary results.”

The Court’s decision not only resolved a circuit split, but also reaffirmed what most courts have held in Chapter 7 proceedings: liens securing valid claims stay with the property until foreclosure or the debt is paid in full.

Ballard Spahr’s Mortgage Banking Group combines broad regulatory experience assisting clients in both the residential and commercial mortgage industries with formidable skill in litigation and depth in enforcement actions and transactions.

For more information, please contact Consumer Financial Services Group Practice Leader Alan S. Kaplinsky at 215.864.8544 or kaplinsky@ballardspahr.com, Christopher J. Willis at 678.420.9436 or willisc@ballardspahr.com, or Scott M. Pearson at 424.204.4323 or pearsons@ballardspahr.com.

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